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Auto Insurance Report National Conference 2009 National Conference Naples, FL April 28, 2009

Who’s Boring Now? Insurers Set the Financial Services Pace Trends & Challenges Amid the Economic Storm. Auto Insurance Report National Conference 2009 National Conference Naples, FL April 28, 2009. Robert P. Hartwig, Ph.D., CPCU, President

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Auto Insurance Report National Conference 2009 National Conference Naples, FL April 28, 2009

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  1. Who’s Boring Now? Insurers Set the Financial Services Pace Trends & Challenges Amid the Economic Storm Auto Insurance Report National Conference 2009 National Conference Naples, FL April 28, 2009 Robert P. Hartwig, Ph.D., CPCU, President Insurance Information Institute 110 William Street New York, NY 10038 Tel: (212) 346-5520  bobh@iii.org  www.iii.org

  2. Presentation Outline • Financial Crisis & The Weakening Economy • Economic & Labor Market Trends • Aftershock: P/C Insurance After the Financial Crisis • 10 Key Threats and Issues Facing P/C Insurers Through 2015 • Green Shoots: Signs of Recovery? • Financial Strength & Ratings • P/C Insurance Industry Overview & Outlook • Profitability • Premium Growth • Underwriting Performance • Financial Market Impacts • Capital & Capacity • Personal Lines Overview • Q & A

  3. THE ECONOMIC STORMWhat the Financial Crisis and Deep Recession Mean for the P/C Insurance IndustryExposure & Claim Cost Effects

  4. Real GDP Growth* Recession began in December 2007. Economic toll of credit crunch, housing slump, labor market contraction is growing The Q4:2008 decline was the steepest since the Q1:1982 drop of 6.4% *Yellow bars are Estimates/Forecasts from Blue Chip Economic Indicators. Source: US Department of Commerce, Blue Economic Indicators 4/09; Insurance Information Institute.

  5. GDP Growth: Advanced & Emerging Economies vs. World 1970-2010F Emerging economies (led by China) are expected to grow by 3.3% in 2009 The world economy is forecast to grow by 0.5% in 2009, but could shrink for the first time since WW II —by 1% to 2% according to the World Bank. Advanced economies will shrink by 1.9% in 2009 Source: International Monetary Fund, World Economic Outlook Update, Jan. 28, 2009; Ins. Info. Institute.

  6. Real GDP Growth vs. Real P/C Premium Growth: Modest Association P/C insurance industry’s growth is influenced modestly by growth in the overall economy Sources: A.M. Best, US Bureau of Economic Analysis, Blue Chip Economic Indicators, 4/09; Insurance Information Inst.

  7. Length of US Recessions,1929-Present* Months in Duration Current recession began in Dec. 2007 and is already the longest since 1981. It is now also the longest recession since the Great Depression. “We will rebuild. We will recover.” --President Barack Obama addressing a joint session of Congress February 24, 2009 * As of May 2009, inclusive Sources: National Bureau of Economic Research; Insurance Information Institute.

  8. Length of U.S. Business Cycles, 1929-Present* Duration (Months) Average Duration** Recession = 10.4 Months Expansion = 60.5 Months Month Recession Started * As of May 2009, inclusive; **Post-WW II period through end of most recent expansion. Sources: National Bureau of Economic Research; Insurance Information Institute.

  9. Annual Inflation Rates(CPI-U, %), 1990-2010F Inflation peaked at 5.6% in August 2008 on high energy and commodity crisis. The recession and the collapse of the commodity bubble have produced temporary deflation. Sources: US Bureau of Labor Statistics; Blue Chip Economic Indicators, April 10, 2009 (forecasts).

  10. Total Industrial Production,(2007:Q1 to 2010:Q4F) Figures for 2010 revised upwards to reflect expected impact of Obama stimulus program Obama stimulus program is expected benefit impact industrial production and therefore insurance exposure both directly and indirectly Industrial production began to contract sharply during H2 2008 and is expected to shrink through most of 2009 Sources: US Bureau of Labor Statistics; Blue Chip Economic Indicators (4/09); Insurance Info. Inst.

  11. Labor Market TrendsFast & Furious: Massive Job Losses Sap the Economy and Workers Comp Exposure

  12. Unemployment Rate:On the Rise January 2000 through March 2009 March 2009 unemployment jumped to 8.5%, exceeding the 6.3% peak during the previous cycle, and is now at it highest level since Jan. 1984 Previous Peak: 6.3% in June 2003 Trough: 4.4% in March 2007 Unemployment will likely peak between 9% and 10 % during this cycle, impacting payroll sensitive p/c and non-life exposures Average unemployment rate 2000-07 was 5.0% Mar-09 Source: US Bureau of Labor Statistics; Insurance Information Institute.

  13. U.S. Unemployment Rate,(2007:Q1 to 2010:Q4F)* Rising unemployment will erode payrolls and workers comp’s exposure base. Unemployment is expected to peak near 10% in early 2010. * Blue bars are actual; Yellow bars are forecasts Sources: US Bureau of Labor Statistics; Blue Chip Economic Indicators (4/09); Insurance Info. Inst.

  14. Monthly Change Employment*(Thousands) January 2008 through March 2009 Job losses since the recession began in Dec. 2007 total 5.133 million; 13.2 million people are now defined as unemployed. Monthly losses in Dec. – Mar. were the largest in the post-WW II period Source: US Bureau of Labor Statistics: http://www.bls.gov/ces/home.htm; Insurance Info. Institute

  15. State Construction Employment, Dec. 2007 – Dec. 2008 WA NH MT ND ME VT MN OR ID MA WI NY SD WY MI RI CT PA NV IA NE NJ OH IL UT IN DE Construction employment declined in 47 of 50 states in 2008 CO WV VA CA KS MO KY MD NC TN AZ DC OK NM AR SC AL GA MS LA AK AK TX FL HI 17 Sources: Associated General Contractors of America from Bureau of Labor Statistics; Insurance Information Institute.

  16. Crisis-Driven Exposure ImplicationsAuto, Home Exposure Growth Slows asSales Nosedive

  17. Auto/Light Truck Sales,1999-2010F (Millions of Units) Weakening economy, credit crunch are hurting auto sales; Gas prices less of a factor now. New auto/light truck sales are expected to experience a net drop of 6.7 million units annually by 2009 compared with 2005, a decline of 39.6% and the lowest level since the late 1960s Impacts of falling auto sales will have a less pronounced effect on auto insurance exposure growth than problems in the housing market will on home insurers Source: US Department of Commerce; Blue Chip Economic Indicators (4/09); Insurance Information Inst.

  18. New Private Housing Starts,1990-2010F (Millions of Units) New home starts plunged 34% from 2005-2007; Drop through 2009 is 73% (est.)—a net annual decline of 1.51 million units, lowest since record began in 1959 Exposure growth forecast for HO insurers is dim for 2009 with some improvement in 2010. Impacts also for comml. insurers with construction risk exposure I.I.I. estimates that each incremental 100,000 decline in housing starts costs home insurers $87.5 million in new exposure (gross premium). The net exposure loss in 2009 vs. 2005 is estimated at about $1.3 billion. Source: US Department of Commerce; Blue Chip Economic Indicators (4/09); Insurance Information Inst.

  19. Crisis ImplicationsTop Crisis-Driven Claim Issues for Personal Lines Insurers

  20. Summary of Short-Run Impacts of Stimulus Package on P/C Insurance • CLAIMING BEHAVIOR • Claim frequency falls with miles driven. History: Drop is temporary. • Claim severity continues to rise: med costs, collisions repair costs up • Likely maintenance on homes, cars deferredclaim. freq/sev. impact? • PURCHASING BEHAVIOR: Efforts to Economize • More shopping around • Increased deductibles • Dropping optional coverages (collision, comprehensive) • Lower limits • Insuring fewer vehicles (3 or 4th vehicle sold) • Insuring older vehicles (old cars retained, new car purchases deferred) • UNINSURED/UNDERINSURED MOTORIST % RISES • Expected to rise from 13.8% in 2007 to 16.1% in 2010 • FRAUD & ABUSE: • Evidence emerging of increased frequency of “give-ups” where car owners underwater on payments commit fraud to obtain insurance money (e.g., car arson, fabricated theft, etc.) • Anecdotal evidence of owner-caused home arson

  21. Percentage Motorists Driving Without Insurance, 2003-2010F A record 16.1% of motorists are expected to be driving without insurance by 2010 as rising unemployment prompts some people to drop coverage In 2007, 1-in-7.2 motorists was uninsured; That figure is expected to rise to 1-in-6.2 by 2010 Source: Uninsured Motorists, 2008 Edition, Insurance Research Council; Insurance Information Institute

  22. Do Changes in Miles Driven AffectAuto Collision Claim Frequency? Paid Claim Frequency = (No. of paid claims)/(Earned Car Years) x 100 Miles driven fell 3.6% in 2008 but collision claim freq was down just 2.6 Sources: Federal Highway Administration (http://www.fhwa.dot.gov/ohim/tvtw/08septvt/index.cfm; ISO Fast Track Monitoring System, Private Passenger Automobile Fast Track Data: Nine Months 2008, published April 1, 2009 and earlier reports. *2008 ISO figure is for 4 quarters ending Q4 2008.

  23. Auto Insurance: Claim Frequency Impacts of Energy Crisis of 1973/4 Oct. 17, 1973: Arab oil embargo begins March 17, 1974: Arab oil states announce end to embargo Frequency Impacts Collision: -7.7% PD: -9.5% BI: -13.3% Frequency began to rebound almost immediately after the embargo ended • Driving Stats • Gas prices rose 35-40% • Miles driven fell 6.7% in 1974 Source: ISO, US DOT.

  24. GREEN SHOOTSIs the Recession Nearing an End?

  25. Hopeful Signs That the EconomyWill Begin to Recover Soon Recession Appears to be Bottoming Out, Freefall Has Ended Pace of GDP shrinkage is beginning to diminish Pace of job losses is leveling off Major stock market indices well off record lows, anticipating recovery Some signs of retail sales stabilization are evident Financial Sector is Stabilizing Banks are reporting quarterly profits Many banks expanding lending to credit worthy people & businesses Housing Sector Likely to Find Bottom Soon Home are much more affordable (attracting buyers) Mortgage rates are at multi-decade lows (attracting buyers) Freefall in housing starts and existing home sales is ending Inflation & Energy Prices Are Under Control Consumer & Business Debt Loads Are Shrinking Source: Ins. Info. Inst.

  26. AFTERSHOCKWhat Will the P/C Insurance Industry Look Like After the Crisis? 6 Key Differences

  27. 6 Key Differences: P/C Insurance in the Post-Financial Catastrophe World • The P/C Insurance Industry Will Be Smaller: The Industry Will Have Shrunk by About 3% in Dollar Terms and by 8% on an Inflation Adjusted Basis, 2007-09 • Falling prices, weak exposure growth, increasing government intervention in private (re)insurance markets, large retentions and alternative forms of risk transfer have siphoned away premium • There will be fewer competitors after a mini consolidation wave • P/C Industry Will Emerge With Its Risk Mgmt. Model More Intact than Most other Financial Service Segments • Benefits of risk-based underwriting, pricing and low leverage clear • There Will Be Federal Regulation of Insurers: Now in Waning Months of Pure State-Based Regulation • Federal regulation of “systemically important” firms seems certain • Solvency and Rates regulation, Consumer Protection may be shared • Dual regulation likely; federal/state regulatory conflicts are likely • With the federal nose under the tent, anything is possible Source: Insurance Info. Inst.

  28. 6 Key Differences: P/C Insurance in the Post-Financial Catastrophe World • Investment Earnings Will Shrink Dramatically for an Extended Period of Time: Federal Reserve Policy, Shrinking Dividends, Aversion to Stocks • Trajectory toward lower investment earnings is being locked in • Back to Basics: Insurers Return to Underwriting Roots: Extended Period of Low Investment Exert Pressure to Generate Underwriting Profits Since 1960s • Chastened and “derisked” but facing the same (or higher) expected losses, insurers must work harder to match risk to price • P/C Insurers: Profitable Before, During & After Crisis: Resiliency Once Again Proven • Directly the result of industry’s risk management practices Source: Insurance Information Inst.

  29. Possible Regulatory Scenarios for P/C Insurers as of Year-End 2009 • Status Quo: P/C Insurers Remain Entirely Under Regulatory Supervision of the States • Unlikely, but some segments of the industry might welcome this outcome above all others • Federal Regulation: Everything is Regulated by Feds • Unlikely that states will be left totally in the cold • Optional Federal Charter (OFC): Insurers Could Choose Between Federal and State Regulation • Unlikely to be implemented as envisioned for past several years by OFC supporters • Dual Regulation: Federal Regulation Layer Above State • Feds assume solvency regulation, states retain rate/form regulation • Hybrid Regulation: Feds Assume Regulation of Large Insurers at the Holding Company Level • Systemic Risk Regulator: Feds Focus on Regulation of Systemic Risk Points in Financial Services Sector • What are these points for insurers? P/C vs. Life? Source: Insurance Information Inst.

  30. 10 Key Threats Facing Insurers Amid Financial CrisisChallenges for theNext 5-8 Years

  31. Important Issues & Threats Facing Insurers: 2009 - 2015 • Erosion of Capital • Losses are larger and occurring more rapidly than is commonly understood or presumed • Surplus down 13%=$66B since 9/30/07 peak; 12% ($80B ) in 2008 • P/C policyholder surplus could be even more by year-end 2009 • Some insurers propped up results by reserve releases • Decline in PHS of 1999-2002 was 15% over 3 years and was entirely made up and them some in 2003. Current decline is ~13% in 5 qtrs. • During the opening years of the Great Depression (1929-1933) PHS fell 37%, Assets fell 28% and Net Written Premiums fell by 35%. It took until 1939-40 before these key measures returned to their 1929 peaks. • BOTTOM LINE: Capital and assets could fall much farther and faster than many believe. It will take years to return to the 2007 peaks (likely until 2011 with a sharp hard market and 2015 without one) Source: Insurance Information Inst.

  32. Important Issues & Threats Facing Insurers: 2009 - 2015 • Reloading Capital After “Capital Event” • Continued asset price erosion coupled with major “capital event” could lead to shortage of capital among some companies • Possible Consequences: Insolvencies, forced mergers, calls for govt. aid, requests to relax capital requirements • P/C insurers have come to assume that large amounts of capital can be raised quickly and cheaply after major events (post-9/11, Katrina). • This assumption may be incorrect in the current environment • Cost of capital is much higher today, reflecting both scarcity & risk • Implications: P/C (re)insurers need to protect capital today and develop detailed contingency plans to raise fresh capital & generate internally. Already a reality for some life insurers. Source: Insurance Information Inst.

  33. Important Issues & Threats Facing Insurers: 2009 - 2015 • Long-Term Loss of Investment Return • Low interest rates, risk aversion toward equities and many categories of fixed income securities lock in a multi-year trajectory toward ever lower investment gains • Price bubble in Treasury securities keeps yields low • Many insurers have not adjusted to this new investment paradigm of a sustained period of low investment gains • Regulators will not readily accept it; Many will reject it • Implication 1: Industry must be prepared to operate in environment with investment earnings accounting for a smaller fraction of profits • Implication 2: Implies underwriting discipline of a magnitude not witnessed in this industry in more than 30 years. Yet to manifest itself. • Lessons from the period 1920-1975 need to be relearned Source: Insurance Information Inst.

  34. Important Issues & Threats Facing Insurers: 2009 – 2??? • Regulatory Overreach • Principle danger is that P/C insurers get swept into vast federal regulatory overhaul and subjected to inappropriate, duplicative and costly regulation (Dual Regulation) • Danger is high as feds get their nose under the tent • Status Quo is viewed as unacceptable by all • Pushing for major change is not without significant risk in the current highly charged political environment • Insurance & systemic risk • Disunity within the insurance industry • Impact of regulatory changes will be felt for decades • Bottom Line: Regulatory outcome is uncertain and risk of adverse outcome is high Source: Insurance Information Inst.

  35. Important Issues & Threats Facing Insurers: 2009 - 2015 • Creeping Restrictions on Underwriting • Attacks on underwriting criteria such as credit, education, occupation, territory increasing • Industry will lose some battles • View that use of numerous criteria are discriminatory and create an adverse impact on certain populations • Impact will be to degrade the accuracy of rating systems to increase subsidies • Predictive modeling also at risk • Current social and economic environment could accelerate these efforts • Danger that bans could be codified at federal level during regulatory overhaul • Bottom Line: Industry must be prepared to defend existing and new criteria indefinitely Source: Insurance Information Inst.

  36. Important Issues & Threats Facing Insurers: 2009 - 2015 • Exploitation of Insurance as a Wealth Redistribution Mechanism • There is a longstanding history of attempts to use insurance to advance wealth redistribution/economic agendas • Urban subsidies in auto; Coastal subsidies are old; Could be extended to workers comp in variety of ways • Insurer focus on underwriting profitability (resulting in higher rates) coupled with poor economic conditions could raise profile of affordability issue • Calls for “excess profits tax” on insurers • Increased government involvement in insurance (including ownership stakes) make this more likely • Federal regulation could impose such redistribution schemes • Bottom Line: Expect efforts to address social and economic inequities through insurance Source: Insurance Information Inst.

  37. Important Issues & Threats Facing P/C Insurers: 2009 - 2015 • Mega-Catastrophe Losses • $100B CAT year is not improbably over the next 5-7 year • Severity trend remains upward • Frequency trends highly variable but more prone to spikes • FINANCING: Unclear if sufficient capital exists to finance mega-cats in current capital constrained environment • Concern over reinsurance capacity and pricing • Alternative sources of CAT financing have dried up • Some regulators will continue to suppress rates • Residual markets shares remain high • Loss of volume for private insurers in key states (e.g., FL) • Serves as entry point for socialization of insurance • Bottom Line: Capacity to finance mega-cats is diminished. Government may fill the void, sometimes with the industry’s support; sometimes in spite of opposition

  38. Important Issues & Threats Facing Insurers: 2009 -2015 • Creeping Socialization and Partial Nationalization of Insurance System • CAT risk is, on net, being socialized directly via state-run insurance and reinsurance mechanisms or via elaborate subsidy schemes involving assessments, premium tax credits, etc. • Some (life) insurers seeking TARP money • Efforts to expand flood program to include wind • Health insurance may be substantively socialized • Terrorism risk—already a major federal role backed by insurers • Eventually impacts for other lines such as personal auto, WC? • Feds may open to more socialization of private insurance risk • Ownership stakes in some insurers could be a slippery slope • States like FL will lean heavily on Washington in the event of a mega-cat that threatens state finance • Bottom Line: Additional socialization likely. Can insurers/will insurers draw the line? Source: Insurance Information Inst.

  39. Important Issues & Threats Facing Insurers: 2009 -2015 • Emerging Tort Threat • No tort reform (or protection of recent reforms) is forthcoming from the current Congress or Administration • Erosion of recent reforms is a certainty (already happening) • Innumerable legislative initiatives will create opportunities to undermine existing reforms and develop new theories and channels of liability • Torts twice the overall rate of inflation • Influence personal and commercial lines, esp. auto liab. • Historically extremely costly to p/c insurance industry • Leads to reserve deficiency, rate pressure • Bottom Line: Tort “crisis” is on the horizon and will be recognized as such by 2012-2014 Source: Insurance Information Inst.

  40. FINANCIAL STRENGTH & RATINGSIndustry Has Weathered the Storms Well

  41. P/C Insurer Impairments,1969-2008 The number of impairments varies significantly over the p/c insurance cycle, with peaks occurring well into hard markets Source: A.M. Best; Insurance Information Institute

  42. P/C Insurer Impairment Frequency vs. Combined Ratio, 1969-2008 Impairment rates are highly correlated with underwriting performance and reached record lows in 2007/08 2008 impairment rate was a record low 0.23%, second only to the 0.17% record low in 2007 and barely one-fourth the 0.82% average since 1969 Source: A.M. Best; Insurance Information Institute

  43. P/C Impairment Frequency vs. Catastrophe Points in Combined Ratio, 1977-2008 Impairment rates are highly correlated with underwriting performance and reached record lows in 2007/08 2008 impairment rate was a record low 0.23%, second only to the 0.17% record low in 2007 and barely one-fourth the 0.82% average since 1969 Source: A.M. Best, PCS; Insurance Information Institute

  44. Number of Impairments by State, 1969-2008 TX, FL and CA have the largest number of impairments. Catastrophe risk plays a big role. Other factors influencing impairments include the political environment and business mix Source: A.M. Best; Insurance Information Institute

  45. Summary of A.M. Best’s P/C Insurer Ratings Actions in 2008* P/C insurance is by design a resilient in business. The dual threat of financial disasters and catastrophic losses are anticipated in the industry’s risk management strategy. Despite financial market turmoil, high cat losses and a soft market in 2008, 81% of ratings actions by A.M. Best were affirmations; just 3.8% were downgrades and 4.0% upgrades *Through December 19. Source: A.M. Best. 53

  46. Historical Ratings Distribution,US P/C Insurers, 2008 vs. 2005 and 2000 2000 2008 2005 A++/A+ and A/A- gains P/C insurer financial strength has improved since 2005 despite financial crisis Source: A.M. Best: Rating Downgrades Slowed but Outpaced Upgrades for Fourth Consecutive Year, Special Report,November 8, 2004 for 2000; 2006 and 2009 Review & Preview. *Ratings ‘B’ and lower.

  47. Reasons for US P/C Insurer Impairments, 1969-2008 Deficient loss reserves and inadequate pricing are the leading cause of insurer impairments, underscoring the importance of discipline. Investment catastrophe losses play a much smaller role. Source: A.M. Best: 1969-2008 Impairment Review, Special Report,Apr. 6, 2008

  48. Critical Differences Between P/C Insurers and BanksSuperior Risk Management Model & Low Leverage Makea Big Difference

  49. How Insurance Industry Stability Has Benefitted Consumers BOTTOM LINE: Insurance Markets—Unlike Banking—Are Operating Normally The Basic Function of Insurance—the Orderly Transfer of Risk from Client to Insurer—Continues Uninterrupted This Means that Insurers Continue to: Pay claims (whereas 50 banks have gone under as of 4/17) The Promise is Being Fulfilled Renew existing policies (banks are reducing and eliminating lines of credit) Write new policies (banks are turning away people who want or need to borrow) Develop new products (banks are scaling back the products they offer) 57 Source: Insurance Information Institute

  50. Emphasis on Underwriting Matching of risk to price (via experience and modeling) Limiting of potential loss exposure Some banks sought to maximize volume and fees and disregarded risk Strong Relationship Between Underwriting and Risk Bearing Insurers always maintain a stake in the business they underwrite, keeping “skin in the game” at all times Banks and investment banks package up and securitize, severing the link between risk underwriting and risk bearing, with (predictably) disastrous consequences—straightforward moral hazard problem from Econ 101 Low Leverage Insurers do not rely on borrowed money to underwrite insurance or pay claimsThere is no credit or liquidity crisis in the insurance industry Conservative Investment Philosophy High quality portfolio that is relatively less volatile and more liquid Comprehensive Regulation of Insurance Operations The business of insurance remained comprehensively regulated whereas a separate banking system had evolved largely outside the auspices and understanding of regulators (e.g., hedge funds, private equity, complex securitized instruments, credit derivatives—CDS’s) Greater Transparency Insurance companies are an open book to regulators and the public Reasons Why P/C Insurers Have Fewer Problems Than Banks: A Superior Risk Management Model 58 Source: Insurance Information Institute

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